Appeal From The United States District Court For The Middle District Of Pennsylvania.
Garth, Becker, Circuit Judges and Fullam,*fn* District Judge. Becker, Circuit Judge, concurring in the result. Fullam, District Judge, concurring.
This action for a refund of federal estate taxes presents the question whether the equal protection clause is offended by a state inheritance tax statute that, as part of a more general scheme which taxes bequests to a decedent's close relatives at a lower rate than bequests to more distant relatives, imposes a higher tax rate on bequests to stepgrandchildren than it does on bequests to stepchildren, the children of one's adopted children, and spouses, among others. The district court held that the distinction was irrational and arbitrary, and so violated the equal protection clause. Unlike the district court, we conclude that the distinction in question is rationally related to a legitimate state purpose. Thus we will reverse the district court's judgment in favor of the taxpayer.*fn1
John C. Kunkel died on July 27, 1970,*fn2 leaving a will which distributed his estate in three portions. First, one-half of the adjusted gross estate was to be used to establish a marital trust ("the trust fund") for the benefit of his surviving spouse, Katherine S. Kunkel. Mrs. Kunkel was to have the income from the trust fund for life, as well as two powers of appointment with respect to the corpus of the trust fund. Under the terms of the will, if Mrs. Kunkel failed to exercise those powers of appointment, the corpus of the trust fund would eventually pass on to her grandchildren -- John Kunkel's stepgrandchildren.*fn3 Second, the will provided for a bequest of $35,000 for each of Kunkel's stepchildren (Mrs. Kunkel's children). Third, the will made a gift of the residue of the estate to the John Crain Kunkel Foundation, a charitable organization under section 501(c) (3) of the Internal Revenue Code of 1954 ("the Code"). In connection with this last bequest, the will specifically provided that all estate, inheritance, and other taxes to which the estate might be subject were to be paid out of the residuary estate. Thus, any estate or inheritance taxes would reduce the amount of the charitable bequest while leaving the other bequests intact.
On October 29, 1981, Kunkel's estate ("the taxpayer") filed a federal estate tax return showing a gross estate of nearly $8,000,000 and a charitable deduction of slightly over $3,000,000. On a taxable estate of $686,742.71, the taxpayer calculated and paid a federal estate tax of $195,044.88. Subsequently, however, the Commissioner of Internal Revenue ("the Commissioner") determined a deficiency of $315,897.67. The taxpayer paid the deficiency but then filed a claim with the Commissioner for a refund of $118,084. It is this sum which is in dispute in the present case.
A full explanation of the nature of the present dispute between the taxpayer and the Commissioner -- a dispute which, though turning on the constitutionality of a state inheritance tax statute, concerns federal tax liability -- requires a brief description of the relevant state and federal inheritance and estate tax laws.
Section 2055(a) (2) of the Code provides that in calculating the federal estate tax, "the value of the taxable estate shall be determined by deducting from the value of the gross estate the amount of all bequests, legacies, devises, or transfers to or for the use of any corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes. . . ." It was under section 2055(a) (2), then, that the taxpayer was qualified to take a charitable deduction for the gift to the Foundation. Section 2055(c), however, limits the amount of the charitable deduction that can be taken when -- as in the present case -- the will provides that all estate and inheritance taxes are to be payable out of the portion of the estate being given to the charitable organization:
Death taxes payable out of bequests. -- If the tax imposed by section 2001, or any estate, succession, legacy, or inheritance taxes, are, either by the terms of the will, by the law of the jurisdiction under which the estate is administered, or by the law of the jurisdiction imposing the particular tax, payable in whole or in part out of the bequest, legacies, or devises otherwise deductible under this section, then the amount deductible under this section shall be the amount of such bequests, legacies, or devises reduced by the amount of such taxes.
In the circumstances of the present case, the taxpayer was allowed under section 2055 to take a charitable deduction equal to the residue of the estate after the bequests to the trust fund and to Kunkel's stepchildren were made, less the amount of estate and other taxes determined to be due. Thus, the exact amount of the bequest to the Foundation -- and so the amount of the charitable deduction allowed under section 2055 -- would depend on precisely how much the federal and state taxes turned out to be.
With respect to the state tax liability, the Pennsylvania Inheritance and Estate Tax Act of 1961 ("the Pennsylvania inheritance tax"), 72 Pa. Stat. Ann. §§ 2485-102 to -1201, imposes a tax of six percent on bequests to "Class A" beneficiaries, and fifteen percent on bequests to "Class B" beneficiaries. See id. §§ 2485-403, -404. "Class B" beneficiaries are all those not included in "Class A"; "Class A" beneficiaries include the grandparents, parents, spouse and lineal descendants, among others. Id. In turn, the term "lineal descendants" is defined to include
all children of the natural parents and their descendants, adopted descendants and their descendants, stepchildren, and children and their descendants of the natural parent who are adopted by his spouse. It does not include descendants of stepchildren or adopted children and their descendants in the natural family, except as above set forth.
Id. § 2485-102(13) (emphasis supplied). Finally, the tax imposed by the Pennsylvania inheritance tax statute is generally assessed at the time that the interest bequeathed by the will passes into the hands of the ultimate beneficiary, although the executor may elect to prepay the tax.
In calculating the amount of Pennsylvania inheritance taxes due, the taxpayer assumed that the bequest establishing the trust fund would be taxed at the six percent rate applicable to gifts to "Class A" beneficiaries. The taxpayer then subtracted this amount from the value of the residue of the estate in computing the size of the charitable deduction under section 2055. The Commissioner, in determining the deficiency, contended that the taxpayer had underestimated the Pennsylvania inheritance tax liability by assuming that the six percent rate applied. As previously noted, if Mrs. Kunkel died without having exercised her powers of appointment, the corpus of the trust fund would, under the terms of the will, eventually be distributed to Mr. Kunkel's stepgrandchildren. As stepgrandchildren are "Class B" beneficiaries, Pennsylvania would at that time assess an additional nine percent tax on the bequest establishing the trust fund, in order to bring the tax rate up to the fifteen percent level assessed on gifts to "Class B" beneficiaries. In that event, the taxpayer would turn out to have underestimated the state inheritance tax ultimately due; consequently, the taxpayer would have overstated the size of the charitable deduction allowable under section 2055. Taking the fifteen percent rate as the applicable one, the Commissioner determined the size of the charitable deduction to be $2,106,520.62, rather than the $3,230,133.12 that the taxpayer had claimed. And that overstatement of the charitable deduction had caused the federal estate tax to be underpaid by $118,084.
In support of his position, the Commissioner relied on 26 C.F.R. § 20.2055-2(b) (1), which provides in part:
If, as of the date of a decedent's death, a transfer for charitable purposes is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. If an estate or interest has passed to, or is vested in, charity at the time of a decedent's death and the estate or interest would be defeated by the subsequent performance of some act or the happening of some event, the possibility of occurrence of which appeared at the time of the decedent's death to be so remote as to be negligible, the deduction is allowable.
The possibility that Mrs. Kunkel would die without having exercised her powers of appointment, the Commissioner asserted, was not "so remote as to be negligible." Thus, there was a nonnegligible possibility that the trust fund would pass to the stepgrandchildren, triggering the imposition of an additional nine percent state inheritance tax. As that nine percent differential would be paid out of the residuary portion of the estate from which the bequest to the Foundation was made, there was a nonnegligible possibility that the charitable bequest "would be defeated [to the extent of the additional inheritance tax] by . . . the happening of some event" within the meaning of the regulation. Under the terms of the regulation, therefore, the Commissioner decided that the taxpayer should have assumed that the fifteen percent tax rate would apply, and that the taxpayer thereby should have claimed the smaller charitable deduction that the higher state inheritance tax rate would imply.
On December 28, 1978, having failed to obtain a refund from the Commissioner, the taxpayer*fn4 sued in federal district court for a refund. On May 30, 1980, both parties moved for summary judgment. The taxpayer argued, among other things, that on the facts of this case the possibility that Mrs. Kunkel would fail to exercise her powers of appointment was so remote as to be negligible. The taxpayer further argued that imposition of the higher rate of taxation would violate the equal protection clause. Noting that under Pennsylvania law, not only a bequest to a surviving spouse, but even a bequest to a stepchild, was taxed at the lower "Class A" rate, the taxpayer contended that to tax the bequest at the higher "Class B" rate simply because it went to the decedent's stepgrandchildren would be utterly irrational. Because the classification violates the equal protection clause, the extra nine percent differential between "Class A" and "Class B" gifts could never be collected, even if the corpus of ...